Risk and Global Economic Architecture:

Why Full Financial Integration May Be Undesirable

Joseph E. StiglitzAEA Meetings

Atlanta, January 2010

Standard Theory

• Argues that global financial integration spreads risk around the world

• And therefore should enhance stability• Recent crisis has shown that in the

absence of appropriate government intervention, privately profitable transactions may lead to systemic risk

Objectives and Results of This Paper

• To provide a general analytic framework within which we can analyze the optimal degree (and form) of financial integration – Focuses on structure of risk sharing– Ignores information problems

• Full integration is not in general optimal• Faced with a choice between two polar regimes,

full integration or autarky, in the simplified model autarky may be superior

• More generally, “circuit breakers” (capital controls) may be desirable

An Analogous Problem

• With an integrated electric grid the excess capacity required to prevent a blackout can be reduced – Alternatively, for any given capacity, the probability of

a blackout can be reduced. • But a failure in one part of the system can lead

to system-wide failure – In the absence of integration, the failure would have

been geographically constrained • Well-designed networks have circuit breakers, to

prevent the “contagion” of a failure of one part of the system to others.

Global Financial Architecture

• Advocates of global financial integration talk about the advantages of risk sharing

• In the context of East Asia crisis (and other crises), they worry about contagion, the spread of “disease” from one country to another

• But these are two sides of same coin• Have advocated full liberalization• But have resisted introduction of circuit-breakers

(imposition of capital controls)

First Intuition

• In the absence of a full set of Arrow-Debreu securities or an effective surrogate, the Nash equilibrium will not be efficient. – The actions of one unit impose externalities on others. – The Greenwald-Stiglitz Fundamental Inefficiency

Theorem [1986] shows that even with rational expectations, so long as risk markets are incomplete, the market equilibrium will be inefficient. • As each market participant makes his investment decision,

he affects the price distribution. – The current crisis illustrates: as each invested more and more

in housing, the price of (say sub-prime) housing would be lower in the event of a state “s” such that they all (or even many) might want to sell.

Implication

• In these second best situations, imposing restrictions on the set of interactions (relationships) may be welfare enhancing. – Trade liberalization between two countries with

negatively correlated outputs may reduce price volatility but increase income volatility, so much so that all groups in both countries are worse off (Newbery and Stiglitz, 1982)

– In an overlapping generations model, capital market liberalization impairs the extent to which a productivity shock at one time is “shared” with future generations and thus can lower ex ante expected utility (Stiglitz 2002).

Second Intuition

• The intuition behind why integration is desirable was based on “convexity”– With convex technologies and concave utility

functions, risk sharing is always beneficial. – If technologies are not convex, then risk

sharing can lower expected utility – The world is rife with non-convexities

• Bankruptcy• Information (Radner-Stiglitz, Arnott-Stiglitz)• Externalities (Starrett)

• Systemic non-convexities– Financial accelerator (Greenwald-Stiglitz,

1993)– Implying effects of a shock can be amplified– And can lead to a process of trend

reinforcement• A firm experiencing a negative shock—forcing it

closer to the brink of bankruptcy—will have to pay higher interest rates, implying an increased likelihood of a further decline in net worth

Transmission of Shocks

• Even without financial market interlinkages, there can be extensive interdependencies through which a shock in one part of the system can be transmitted to others – Liquidity crises are associated with “forced” sales of

assets, leading to price declines, adversely affecting any bank lending on the basis of collateral

– The declining value of assets induces a reduction in asset-backed lending, with macro-economic consequences

• Financial linkages, while they may enhance risk sharing, may increase these adverse effects

Financial Interlinkages

• Bankruptcy cascades (Greenwald and Stiglitz, 2003; Gale and Allen, 2001) – The bankruptcy of one firm affects the likelihood of the

bankruptcy of those to whom it owes money, its suppliers and those who might depend upon it for supplies; and so actions affecting its likelihood of bankruptcy have adverse effects on others.

• Further externalities are generated as a result of information costs and imperfections. – If unit i doesn’t fully know other units’ characteristics—including

the relationships (contracts) of those with whom it engages in a relationship, including all the relationships with whom those are engaged, ad infinitum—it cannot know the risks of their honoring their contract.

Financial Architecture• The “architecture” of the credit market can affect the risk that one

bankruptcy leads to a sequence of others– If A lends to B, B lends to C, and C lends to D, then a default in D can

lead to a bankruptcy cascade – On the other hand, if lending all goes through a sufficiently well

capitalized clearing house (a bank), then a default by one borrower is not as likely to lead to a cascade

– But a very large shock which leads to the bankruptcy of the “clearing house” can have severe systemic effects

• Reducing the set of admissible relationships and behaviors can have further benefits– Reducing the scope for these uncertainties– Reducing the potential for information asymmetries – Reducing the burden on information gathering

• In large non-linear systems with complex interactions, even small perturbations can have large consequences– Understanding these interactions major research agenda

A Canonical Model • Assume that output in country i is a function of a random variable, Si

– Si can be thought of as the stock of available capital • Production is linear in S, provided S is greater than some critical

number S*, at which point system failure occurs, and a loss of –C occurs

• Assume that Si = -α1 with probability p, α2 with probability 1 – p, p α1 = (1 – p) α2

expected output without bankruptcy is zero (just a normalization). • For simplicity, we assume S* = 0 and C < α1 and 2 < α1, i.e. p < .5

– There is a small probability of “disaster,” which is uncorrelated across countries

Evaluating Liberalization (N=2)

• Prior to liberalization, expected output is given by

- pC + (1 – p)α2 = p (α1 – C) • With liberalization, p (Σ Si /2 < 0) = 1 – (1 - p)2, i.e. both countries go bankrupt if only one country

has a bad outcome• Expected output (per country) is (1 – p)2 α2 - C (1 – (1 - p)2) < - pC + (1 – p)α2• Liberalization is unambiguously welfare

decreasing

Results Can Be Generalized

• Assume bankruptcy occurs if ΣS/N ≤ K ≤ 0 • There is a critical p* for each N and K such

that if p ≤ p*(N,K) liberalization is not desirable

• If disaster occurs “rarely but badly” then liberalization is not desirable

Optimal Sized Clubs

• Consider a simple global financial architecture in which countries are divided into “clubs,” and there is full integration within the club, and no “capital flows” across clubs.

• Then, in general, there is an optimal size of the club, i.e. neither autarky nor full liberalization is desirable– Size depends on benefits of integration (concavity of

utility function) and risks

Restrictions on Capital Flows (Circuit Breakers)

• Simulations within a variant of our model show that an appropriately designed circuit breaker (restrictions on capital flows) can be welfare enhancing.

Asymmetric Patterns

• Our canonical model also assumed symmetric relationships in which all ties/contracts were identical

• In the presence of convexities, such symmetric arrangements often characterize optimal designs

• But that is not so in the presence of non-convexities, and there are many alternative architectures – For instance, a set of countries can be tightly linked (a “common

financial market”) to each other, but the links among financial markets may be looser. The former is designed to exploit the advantages of risk diversification, the latter to prevent the dangers of contagion

• Circuit breakers might be absent in the former but play a large role in the relations among the “common markets”

Further Comments

• Benefits of risk sharing (diversification) reduced with correlation– Incentive structures encourage correlation– Example of divergence of social and private returns

• Analysis also ignores the diminution of asset quality that results from increasing information imperfections typically associated with more extensive financial market integration, and especially securitization

Further Applications

• Our analysis has focused on global financial integration; many of the same issues arise domestically—in the design of domestic financial architecture – Issue of universal banks versus sector banks

• While the real estate banks may fail more often than they would have if they were more diversified, the financial system as a whole might fail less frequently

Rich Research Agenda Ahead

• Even ignoring issues raised by learning, information asymmetries, and institutional coordination, it has been shown that full integration may be less desirable than previously thought

• Standard models cannot be relied upon to provide insights into either the benefits of integration or the appropriate “rules” of the game

Beginning of a Literature Exploring Implications of Alternative Financial Architectures

• Allen, Franklin and Douglas Gale, “Financial Contagion,” Journal of Political Economy, 108(1), 2000, pp. 1-33.

• Battiston, Stefano, Domenico Delli Gatti, Mauro Gallegati, Bruce Greenwald, and Joseph E. Stiglitz, “Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk,” paper presented to the Eastern Economic Association Meetings, February 27, 2009, New York.

• Delli Gatti, Domenico, Mauro Gallegati, Bruce Greenwald, Alberto Russo, and Joseph E. Stiglitz, “Business fluctuations in a credit-network economy” Physica A, 370 (2006), pp. 68-74.

• Gallegati, Mauro, Bruce Greenwald, Matteo G. Richiardi, Joseph E. Stiglitz, “The Asymmetric Effect of Diffusion Processes: Risk Sharing and Contagion,” Global Economy Journal 8(3), 2008.

• Greenwald, Bruce and J. E. Stiglitz, Towards a New Paradigm of Monetary Economics, Cambridge: Cambridge University Press, 2003

• Stiglitz, Joseph E. “Contagion, liberalization, and the optimal structure of globalization,” IPD discussion paper, Columbia University, 2009.